Inflation - why it's different this time

Investors are once again being warned about the dangers of an increasingly inflationary environment. But the causes aren't the same as the last time round, the 1970s, and things are likely to pan out very differently. Can Central Banks kill of the excess money without too much pain?

By MoneyWeek

published 18 August 2006

in Features

Louis-Vincent Gave, Charles Gave together with Anatole Kaletsky are GaveKal Research who, in their recently published book "Our brave new world" claimed very bravely that this time it is different'. The new business model, they explained, is unique to the conditions prevailing today. The way in which it is different was highlighted in a recent essay by Louis-Vincent Gave. This essay "The Invisible Hand's Impressive Work" was recently presented by John Mauldin in his weekly Outside the Box' letter at investorinsight.com.

Gave identified the very different driving forces behind China and America's economic progress. Business in China, he said, is about creating jobs; business in America is about creating profits. The latter has no difficulty taking advantage of the former. That, he claimed, is fundamental to America's economic future and ensures the continued profitability of the American model. On that matter we disagree because in the end, no matter how clever the American commercial world is in reinventing itself, a drought of consumers, which is inevitable, will adversely affect even this most modern of business concepts.

Inflation: why it's getting more expensive to be rich

One consequence of this business model in the US is to increase the cost of those services in demand that uniquely require American labour. Manufactured goods are cheap but services, especially at the luxury end, are expensive. Louis-Vincent Gave is quite famous for his observation that being rich has never been more expensive than it is today school fees, restaurants, five-star hotels, air flights and houses are much more expensive.

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Core inflation rates are calculated without regard to this factor and so understate the cost of living for the well off'. The observers of this scene are essentially in that well off' bracket and therefore find it very logical to refute the low inflation figures, claiming inflation is in fact much higher.

Inflation: what the Chindia factor means

It's never the same the second time around and this applies to the subject of inflation as much as for anything else. In the 1970s when inflation was rising to its grim heights, a higher oil price was fundamental to the problem it was passed on easily by manufacturers and consumers had the power to demand higher wages to meet those higher costs, today that is no longer the case. The Chindia factor is very real and if anything, the price of manufactured goods is likely, in the future, to be lower rather than higher.

The problem in China is that the workforce is growing rapidly and there are already too many manufacturers. There is already a glut of supply and for this to be satisfied they rely upon American consumers. If American consumers subside, as they surely must, then demand will fall. The over-supply will become an embarrassment, driving prices even lower. Shelves of goods in Wal-Mart that refuse to empty will be deeply discounted.

Inflation: the excess credit supply

Inflation is fuelled by Central Banks' credit creation, of which there have been record amounts. Everyone has heard of the old saying "too much money chasing too few goods". What we have seen however, is inflation only occurring in those areas where there is a genuine limit to supply, there are only so many top West End restaurants, there are only so many mansion-style houses, so that the prices of these inevitably rises. Where the supply of goods overwhelms, prices in the future must fall.

It might be argued that the excessive supply of credit and the printing of money by Central Banks, has warded off their bitter enemy deflation. Central Bank loose monetary policies ensured not only the avoidance of deflation but also triggered a rising inflationary environment. But that's not how it will pan out. Instead, there is this other process euphemistically called debt forgiveness' but also called bankruptcy' that will go a long way to killing off that excess money in the system. Asset markets that have been driven higher by excessive credit supply are in the final analysis fundamental ingredients to a deflationary outcome. When the asset prices that have been driven higher by cheap credit become the subject of distressed selling, two important things happen:

1. As a result of bankruptcies, some money is literally lost forever.

2. Providers of credit become utterly risk averse.

Inflation: bankruptcies on the rise

The problems in the American housing market and the rising bankruptcies in the UK tell us that process has started and having started, more likely than not, will finish. For the time being, the ongoing performance of UK long-dated gilts will measure how it is proceeding. If current levels are held and, even more so, if gilt markets start to meaningfully rise, then expect deflation to become the nemesis of Central Banks. One of their only weapons to fight it will be credit easing but this won't work very well if the credit easing is taking place at a time when providers of credit, the commercial banks, have become risk averse.

Some years ago, when trying to explain how we saw these events, we came up with the idea of saying "Imagine the economy is a car". If the driver pushes the gear lever into D for drive, puts his foot flat on the floor, the car will move forward very quickly. The same driver could instead put the gear lever into R for reverse, put his foot flat on the floor and the car will move backwards very quickly. So what you have is the same car with the same force being applied to it but because the car is set up differently it has the opposite effect. So it is, we believe, with the economy. The economy today is set up quite differently to how it was 30-years ago. We would contend that in the 1970s the lever was in D and inflation was the consequence when the force of higher energy prices was applied. Now the lever is in R and the same force will cause the opposite effect of deflation.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit https://www.rhasset.co.uk/